September 9, 2007: Income Property, a few basics, part three

Picture: Rumor has it that this is what Phoenix, Arizona may look like because of Global Warming.

The common equation for determining the value of a property is Value equals Net Operating Income (NOI) over Market Capitalization Rate (percentage return on the investment). Net operating income represents the property's rents minus expenses. Essentially, this is the real estate investor's version of the Price/Earnings ration (PE) we all use to evaluate stocks.

Calculating NOI correctly is the key to purchasing a property. Many investors fail to do this, especially the "no money down" crowd.Short term novice "spec flippers" also screw this up - almost always.

Here are NOI ideas that will allow you to make a better calculation:

1. Gross Potential Rents: Use the [property's existing rental records. If its current rents sit above market, use market rate rent levels. Verify all Leases for rental amounts and lease terms. Do not use a figure based upon anticipated rents.

2. Extra Income: With many properties you can charge for rental application fees, parking,storage, laundry, garages, etc. Don't project extra income that has not been proven by past experience or proven market data. I generally do not charge "nickel and dime" fees to tenants. I want a large universe of applicants and too many fees just show the prospective tenant your anal tendency, which is nor a god thing.

3. Vacancy and Collection losses: Use the market vacancy rates or the current owner's vacancies for the past year - whichever is larger. Vacancy rates will vary significantly by location, apartment size, quality and rent level.

4. Effective Gross Income: It is from this cash that you will pay property expenses and mortgage payments. If you overestimate rent levels or underestimate vacancies, you may end up cash short.

5. Trash: Verify rates. Look for lower cost alternatives.

6. Utilities: In addition to common area lighting, some buildings include centralized heat and air systems. Verify the amounts of these expenses with the utility companies. Avoid centralized HVAC systems. My experience has been that they are a money pit for investors.

7. License and Permit Fees: On occasion, owners of rental properties are required to pay municipal fees of one kind or another.

8. Lease-Up Expenses: Ideally, you will generate a good supply of rental applications from free postings, referrals and inquiries. Otherwise, you may have to advertise. As fewer and fewer people read read the newspaper, think creatively with local churches, community organizations, retail store posting boards, etc. Also, credit checks cost money.

9. Management Fees: Even if you self-manage your units, allocate some expense fees for your time and effort. Don't confuse return on labor for return on investment.

10.Maintenance and Repairs: Enter an expense to pay yourself and others. "I'll take care of that myself" should not equate to "I'll work for free".

11.Grounds Maintenance: Yard care means mowing the lawn, trimming hedges, removing snow, cleaning up leaves, picking up after storms, etc.

12.Miscellaneous: Yes, the famous catch-all. You will incur such odds-and-ends expenses as Lease preparation, auto mileage and long distance telephone charges.

13.Property Taxes: Verify amount, tax rate and assessed value.Check for accuracy. Note whether the property is subject to any special assessments (sewer, sidewalks, street paving, sewer upgrading,etc.)

14.Property and Liability Insurance: Verify exact coverage for property and types of losses. Increase deductibles and limits on liability.

15.Reserves for Replacement: Eventually, you will need to replace the roof, HVAC,appliances, carpeting and other limited life items. Allocate a pro rata amount here.

16.Net Operating Income (NOI): Subtract all expenses from effective gross income. You now can determine the value of your property more accurately. Remember to take into account the nearby actual sales comps for properties whose characteristics are similar to yours.

I would also ask for a copy of the seller's Schedule E form submitted the previous year to the IRS. You may gain insight if it is properly prepared - and a few laughs if it isn't.